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Big and Small Companies: Divergences You Must Follow

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Remember that a bifurcated earnings season doesn't equal sustainable recovery.

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As investors move deeper into the thick of earnings season, the perspective as to its meaning for near-term stock-market action becomes of great value. What I'm referring to specifically is to watch for any divergence in earnings performance between big and smaller companies.

For investors, the key aspect of this potential earnings divergence -- one in which large companies meet or exceed earnings expectations while their smaller brethren (those that are less exposed to the global economy and more exposed to the US economy) don't -- is whether the stock-market performance of each group will reflect this potential earnings divergence.

Should earnings diverge, it's logical to assume that the stock-market action should also diverge: Big stocks make new recovery highs, smaller stocks (mid-, small-, and micro-cap) don't. But logical to assume is a phrase that's less suited for liquidity-driven markets, which is what I believe we're experiencing with this market rally. To be sure, my more skeptical view isn't shared by the strongly bullish among us who believe in a V-shaped economy recovery that will validate the V-shaped stock market-rally experienced thus far.

To help put some color into the factors noted above, consider the following chart and tables regarding the stock-market performance from a size perspective, and the earnings expectations -- along with their corresponding P/Es -- for this and next year.



The chart shows the past two months of price performance. It's clearly visible that the new highs made in the S&P 500 are confirmed by new highs in the mid, small, and micro cap sectors.

Now let's look at the earnings expectations for each segment.









As the tables make clear, the growth expectations for all three sectors are quite robust. While I have no problem with the large-cap S&P 500 growth rates in earnings for this and next year, the mid-cap S&P 400 and small-cap S&P 600 are each another story.

Investment Strategy Implications

Given the fact that no stock-market-performance divergences have emerged and that the higher high reached by the broad market S&P 500 has been reached, we're back to square one when it comes to predicting the inevitable major market top -- a point that I described in some detail on my blog this past Tuesday.

As noted on my blog, fully synchronized confirmed highs aren't the stuff of major declines beyond the moderate 3% to 5% variety. This is exactly what occurred from the previous high reached in mid-September -- from intra-day high of 1080 (September 23) to intra-day low of 1019 (October 2) equaled a drop of 5.6% (closing prices of 1063 and 1025 produced a 3.5% decline in value).

What I'll be watching for very closely will be two factors:

1. Will the more US-centric mid- and small-cap companies produce earnings this and next quarter to warrant the enthusiastic conclusions reached by the bottom-up analysts?

2. Will the stock-market performance of the mid- and small-cap sectors confirm or diverge from the large-cap sector should stocks continue to make new highs?

My money is on the non-confirmation-high scenario rooted in a bifurcated earnings season. The implications of a bifurcated earnings season is a hollowing out of the US economy with big, multinational companies winning while US-centric companies (along with the US worker) losing.

As I mentioned several weeks ago in Sustainability Should Top the Economy's To-Do List, sustainability is key. A bifurcated earnings season doesn't imply a sustainable US recovery.
No positions in stocks mentioned.
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